ITALY’S escalating financial debt problems are the biggest threat to European banks, not Turkey’s crisis with the lira, an income strategist has warned.

The southern European country, which has the third largest economy in the European Union, has a significantly high debt pile of 130 percent of GDP - the second largest in the eurozone.

In July, Italy’s £1.9 trillion ( €2.1 trillion) debt increased by 1.6 points, making it the third highest debt-ridden state after Belgium, which has shown a 2.9 point increase, and Greece, up 1.8 points, according to figures from Eurostat.

Its recently appointed coalition Government, led by Prime Minister Giuseppe Conte, are currently working on next year’s budget.

The financial plan will be closely scrutinised by European authorities and market players, following pledges to increase benefit spending and accelerate tax cuts, despite the possibility of this costing as much as €120 billion (£107 billion) in the first full year.

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If the budget due in October, is now approved by market players, then Italy’s borrowing costs are likely to skyrocket, which could cause a domino effect on neighbouring European countries and European banks that hold Italian debt.

Tom Kinmonth, fixed income strategist at Amsterdam-headquartered bank ABN Amro and the third largest in the Netherlands, told CNBC’s ’Squawk Box Europe’: “The biggest that is far, far more important is Italy.

“The Turkey issue is something on the radar but all eyes will be on Italy over the next three months.

“We can talk about the UniCredit exposure to Turkey of 3-4 percent, but UniCredit is 50 percent exposed to Italy and has over 50 billion in Italian sovereign debt.

Giuseppe Conte's Government are working on next year's budget, which will be closely scrutinised (Image: UK)

“We have issues on Banka Carige possibly failing, and we have the discussion from Moody’s over whether to downgrade the sovereign.

“It’s really beginning to hot up and the impact that Italy has, as we’ve seen before year after year, it’s really going to impact the banks.

“The issues in Italy in the next three months are going to dictate the whole European banking narrative for the next 3-4 years.”

Mr Kinmoth added that apart from the budget, there are a number of other events that could cause trouble for European banks.

Ratings agencies are due to update their opinions on Italy - the country’s banks still hold a high level of non-performing loans and the uncertainty surrounding its political landscape is making it increasingly difficult to predict what might happen to banks as a result.

On Monday, Italy reportedly contacted the European Central Bank to discuss the debt crisis after Government bonds reached their highest since the general election in June.

Claus Vistesen, chief euro-zone economist at Pantheon Macroeconomics, said: “What’s most worrying is that the Italian government still appears to be in a fighting mode.

“It seems to welcome a potential confrontation with the EU and markets over its budget, probably because it judges that it gains political capital at home by taking such a confrontational line.

Tayyip Erdogan said Turkey would boycott electronic products from the US (Image: GETTY)

"This is not good news for markets.”

The Turkish lira has lost more than 40 percent of its value this year and on Monday crashed to an all-time low of 7.24 to the US dollar, hit by worries over President Tayyip Erdogan’s calls for lower borrowing costs and worsening ties with the US.

On Tuesday, the currency recovered, trading at 6.4 to the dollar at 1751 GMT - up almost eight percent from the previous day’s lose and having earlier touched 6.2995.

Mr Erdogan said that Turkey would boycott electronic products from the US, retaliating in a row with Washington that has helped drive the lira to these record lows.